The Advantages of Firms Over Markets Are:: Control Risks

Transaction costs
Transaction costs will occur when dealing with another external party:
 Search and information costs: to find the supplier.

 Bargaining and decision costs: to purchase the component.
 Policing and enforcement costs: to monitor quality.
The way in which a company is organised can determine its control over transactions, and hence costs. It is in the
interests of management to internalise transactions as much as possible, to remove these costs and the
resulting risks and uncertainties about prices and quality.
 For example a beer company owning breweries, public houses and suppliers removes the problems of
negotiating prices between supplier and retailer.
Transaction costs can be further impacted:
Bounded rationality: our limited capacity to understand business situations, which limits the factors we
consider in the decision.
Opportunism: actions taken in an individual's best interests, which can create uncertainty in dealings and
mistrust between parties
The significance and impact of these criteria will allow the company to decide whether to expand internally (possibly
through vertical integration) or deal with external parties.
The variables that dictate the impact on the transaction costs are:
 Frequency: how often such a transaction is made.

 Uncertainty: long term relationships are more uncertain, close relationships are more uncertain, lack of trust
leads to uncertainty.
 Asset specificity: how unique the component is for your needs.
 The advantages of firms over markets are:
 * internal organization are able to invoke fiat to resolve differences
 * better access to information
 Incentive to shift transactions inside the firm increases with uncertainty
Jensen and Meckling explore the relationship between owners and

managers and underline the way to align interests of all subjects.
In general, the paper is known for highlighting the conflict of interest between
principals and agents. Typically, this is linked to relationship between owners
and managers.
Agency costs – The principal can limit divergences from his interest by
establishing appropriate incentives for the agent and by incurring monitoring
costs designed to limit the aberrant activities, of the agent. – In addition in some
situations it will pay the agent to expend resources (bonding costs) to guarantee
that he will not take certain actions which would harm the principal or to ensure
that the principal will be compensated if he does take such actions. – However,
it is generally impossible for the principal or the agent at zero cost to ensure
that the agent will make optimal decisions from the principal’s viewpoint. •
Agency costs are the sum of: 1. the monitoring expenditures by the principal, 2.
the bonding expenditures by the agent, 3. the residual loss.
signaling theory: MM assumed that: 1.Systematic information: Investors have

the same information about a firm prospects as its managers. 2.Asystematic
information: Infact managers often have better information than outside
investors.
signaling: Based on asystematic information. Positive and negative signal:
1.Equity issue: Taken as negative signal by investors result in fall of stock price.
Investor percieve that company is in loss, that result in the decline in the
demand of share prices, which result in the decrease in the share prices.
The first version of the M&M theory was full of limitations as it was developed
under the assumption of perfectly efficient markets, in which the companies
do not pay taxes, while there are no bankruptcy costs or asymmetric
information
Subsequently, Miller and Modigliani developed the second version of their
theory by including taxes, bankruptcy costs, and asymmetric information.
The M&M Theorem in Perfectly Efficient Markets
This is the first version of the M&M Theorem with the assumption of perfectly
efficient markets. The assumption implies that companies operating in the
world of perfectly efficient markets do not pay any taxes, the trading of
securities is executed without any transaction costs, bankruptcy is possible but
there are no bankruptcy costs, and information is perfectly symmetrical.
Proposition 1 (M&M I):
Where:
 VU = Value of the unlevered firm (financing only through equity)

 VL = Value of the levered firm (financing through a mix of debt and
equity)
The first proposition essentially claims that the company’s capital structure
does not impact its value. Since the value of a company is calculated as the
present value of future cash flows, the capital structure cannot affect it. Also, in
perfectly efficient markets, companies do not pay any taxes. Therefore, the
company with a 100% leveraged capital structure does not obtain any benefits
from tax-deductible interest payments.
Proposition 2 (M&M I):

Where:
 rE = Cost of levered equity

 ra = Cost of unlevered equity
 rD = Cost of debt
 D/E = Debt-to-equity ratio
The second proposition of the M&M Theorem states that the company’s cost
of equity is directly proportional to the company’s leverage level. An increase
in leverage level induces higher default probability to a company. Therefore,
investors tend to demand a higher cost of equity (return) to be compensated
for the additional risk.
M&M Theorem in the Real World
Conversely, the second version of the M&M Theorem was developed to better
suit real-world conditions. The assumptions of the newer version imply that
companies pay taxes; there are transaction, bankruptcy, and agency costs; and
information is not symmetrical.
Proposition 1 (M&M II):
Where:
 tc = Tax rate

 D = Debt
 The first proposition states that tax shields that result from the tax-
deductible interest payments make the value of a levered company
higher than the value of an unlevered company. The main rationale
behind the theorem is that tax-deductible interest payments positively
affect a company’s cash flows. Since a company’s value is determined as
the present value of the future cash flows, the value of a levered
company increases.

 Proposition 2 (M&M II):



 The second proposition for the real-world condition states that the cost
of equity has a directly proportional relationship with the leverage level.
 Nonetheless, the presence of tax shields affects the relationship by

making the cost of equity less sensitive to the leverage level. Although
the extra debt still increases the chance of a company’s default,
investors are less prone to negatively reacting to the company taking
additional leverage, as it creates the tax shields that boost its value.


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Transaction costs

 Search and information costs: to find the supplier.

Transaction costs can be further impacted:

 Frequency: how often such a transaction is made.

Jensen and Meckling explore the relationship between owners and

signaling theory: MM assumed that: 1.Systematic information: Investors have

The M&M Theorem in Perfectly Efficient Markets

Proposition 1 (M&M I):

 VU = Value of the unlevered firm (financing only through equity)

Proposition 2 (M&M I):

 rE = Cost of levered equity

M&M Theorem in the Real World

Proposition 1 (M&M II):

 tc = Tax rate

 Proposition 2 (M&M II):

 Nonetheless, the presence of tax shields affects the relationship by

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